Stephen Koukoulas

The illion (formerly Dun & Bradstreet) Business Expectations Survey presented an confident outlook for the economy as 2018 kicked off.

According to the survey, a resilient Construction sector and resurgent Manufacturing industry have the most confident outlook for the first quarter of 2018, according to illion’s latest Business Expectations Survey. Driven by strong expectations for profits, selling prices, capital investment and employment, both sectors topped the final indices for the March quarter, with manufacturing confidence at its highest level since June 2003.

2018 is starting on a positive note for the economy with both business expectations and the actual performance of the business sector at multi-year highs. It would appear that the positive tone from a stronger global economy, together with low interest rates and a competitive level for the Australia dollar are all providing a tail wind for the business sector.

The bad news is that exports are falling, despite a strong global economy and some strength in commodity prices. At the same time, imports have picked up partly because of the overvalued level of the Australian dollar and partly because of an increase in capital goods imports which are picking up in line with the improvement in business investment.

In November, Australia registered a monthly deficit of $628 million on trade in goods and services which was the second deficit in a row and it sits in stark contrast to the monthly trade surpluses around $3 billion in late 2016 and early 2017. The weakness in exports is surprising. The world economy is strong with growth getting close to the best in a decade. Commodity prices are rising in line with the global strength which should be adding significantly to our export receipts. The fact that exports have been falling for nine straight months in trend terms is probably best explained by the strength of the Australian dollar which is more than offsetting the positive influences. The strong Aussie dollar, it should be noted, is being held up by Australia’s relatively high interest rates.

In the 34 years since the Australian dollar was floated, there have been numerous examples of how a high (overvalued) Australian dollar has eroded the international competitiveness of the export sector.

Eight days into 2018 and the Corelogic price series shows that Sydney house prices have edged a further 0.1 per cent lower since 31 December 2017.

Not a large fall, to be sure, but it builds on the falls in Sydney house prices recorded in October, November and December. It is signaling the impact of the quadrella of headwinds in the form of new supply, tighter lending rules, rising interest rates for investors and better investment opportunities in other asset classes.

From the peak in early September 2017, Sydney house prices have fallen by 2.5 per cent. That’s about $25,000 on a $1,000,000 property.

The price decline, to date, has been orderly and still small in the context of house prices doubling over the previous decade. But it does mean that some of the powerful wealth effects that helped to fuel the New South Wales economy will be missing in 2018, and perhaps beyond. If the falls become more acute, there could be some spill-over problems to the broader economy.

The betting markets are fielding on the next Federal election and at the moment, the punters are saying Australians are set to elect the Labor Party to office.

There are several bookies offering odds and the best odds available are $1.62 for Labor and $2.60 for the Coalition. Allowing for the bookies margins, the probabilities are approximately 65 per cent chance of a Labor win and about a 35 per cent change of a Coalition win. This means Labor are a 2 in 3 chance of winning, with the Coalition a 1 in 3 chance. Enough of the lesson of odds.

Betting markets are not particularly reliable when elections are 6 to 12 months away. But the close the election is, the more accurate they become. Recent high profile exceptions were Brexit and Trump, but even there, the odds of both of those results was no wider than $5 a week or two from polling day.

2018 is kicking off with the share market trading at its highest level in almost a decade and the housing market starting to weaken, with prices falling in Sydney, Perth, Darwin and Melbourne, and flat-lining or slowing in Adelaide, Brisbane and Canberra. House prices in Hobart are the only shining light amid the increasing nation-wide gloom on housing.

These unfolding trends present an interesting choice for investors, who in recent years have generally been well rewarded with a high allocation of investment funds towards housing and a lesser allocation to stocks.

This is changing and could well be set to continue through the course of 2018 and beyond. The prospect of half a decade of flat or falling house prices is not conducive for investors, almost regardless of the alternatives.

The dynamics of housing are well understood. Extraordinary prices gains over the past decade or so have delivered stellar returns, albeit with a relatively low rental yield, rising costs of ownership (council rates, insurance and the like). The very low interest rates that provided financial comfort to investors as many maximised their debt on the expectation house price rises would offset those costs is less and less relevant as prices start to fall. In other words, with house prices now flat and falling, these dynamics mean that investing in housing is at best marginal, even with the absurdly generous tax policies in the form of negative gearing. Add to that a rise in the interest rate the banks charge investors as a result of the regulatory changes imposed by the Australian Prudential Regulatory Authority, and it is fair to say housing, as an investment, has almost no appeal.

It’s that time of the year – to stick necks on the forecasting chopping block in an attempt to anticipate important trends in the economy and financial markets.

It is important to have some idea where things are going, whether you are an individual with savings, a mortgage or superannuation, a small business person, someone involved in business or indeed government.

So here are my calls for 2018.

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1. Global stocksHaving registered terrific growth in recent years, a cyclical pull-back in stocks seems to the on the cards during 2018. “Don’t fight the Fed” might prove to be apt again with a near certain continuation of monetary policy tightening from the US Federal Reserve and a wind back in QE. Overlay other policy/political risks from the Trump administration, I would be looking for the S&P500 to fall by 10 per cent or so to around 2,150 (or lower), the Dow down to 21,800 and would kick off the year with a trade to capture that sort of decline. Risk: Further downside

2. The ASX

Australian stocks are inexorably linked to commodity prices and the housing cycle, both of which are erring on the down side. With a probable change in global sentiment towards stocks, the ASX200 is forecast to pull back to 5,750 through the year. So not a bad result, but more likely down than up. Risk: Upside

During a holiday clean up, I came across an email that my former colleague at TD Securities, Jacqui Douglas (who is now Chief European Macro Strategist in London), circulated a little before I left.

It was apparently a list of rules that David Rosenberg, Chief Economist at Merrill Lynch at the time, circulated about being a good and relevant market economist.

The list, reproduced below, should be seen as an Economists Constitution. For those in the business of economic forecasting and market strategy, read it and see how many of the rules you stick to and how many you break. It is a lot of fun and certainly something that should also be read by those covering economics and markets, especially those who seem to have a strong bias to give oxygen to those who break most of these rules.

A year ago, I outlined 10 top calls and forecasts for 2017 for the economy, markets and policy.

The full text of those calls are included below, and my self-rating of the success out of 10 for each of them is in the square brackets in bold. I have tried to reflect the underlying success of the forecast and whether there was money made by taking a position in markets on the basis of those forecasts.

Let me know if you disagree.

In 2016, I got a borderline 50% for my forecasts – it was a mediocre year.

This year has been a whole lot better at 62 per cent which, when it comes to forecasting, economics, policy and markets, is a great result.

I am happy, most of my clients are happy and my 2018 calls will be out in the next day or two.

Cheers, Stephen

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1. Global stocks

When the dust settles from the irrational market reaction to the US Presidential election win of Donald Trump, US (and most global) stocks seem set to fall. Trump policies in trade, foreign affairs, accountability on government spending and tax could all conspire to undermine confidence when the reality of the misguided policy strategy of Trump moves to reality. How much weakness is hard to say, but the Dow, for example, back to 17,500 would seem likely. It could fall further than this. [0/10 By far the worse call, and hopelessly wrong. The geopolitical issues did not amount to zac, the markets appear to be unaware of the issues associated the crunching of the US budget position, and the tax cuts were a positive for markets. US stocks boomed and I was wrong.]

2. The ASXWith the bearish lead from the US, a likely dip in commodity prices and a firm Australian dollar, expect some pull back during 2017. The ASX may hit 6,000 in the early part of the year, as local interest rate cuts are delivered but the negative influences from offshore will likely counter that. A dull forecast, in many ways, but 5,250 for the ASX200. [4/10 It was a solid year for the ASX with a gain of about 7 per cent, 31 December on 31 December. It hit 6,000 points late in the year, not early, which was a favourable position to take at the start of the year. My within year forecast was askew.]

Despite all the spin and torture of the data, government debt is still rising, the return to budget surplus is based on fickle economic forecasts and the Turnbull government is on track to be one of the top 10 taxing governments in Australia’s history.

Gross government debt is already at a record at $520 billion and it will keep rising through till at least 2027-28 when it will reach a new record high just under $700 billion. Net government debt (which allows for some of the assets the government owns to offset gross debt), will reach a peace-time record in 2018-19 when it hits 19.2 per cent of GDP, having roughly doubled from the time of the 2013 election.

This is a long way from promises of the Liberal Party prior to it taking office to run budget surpluses and pay off debt.

With Treasurer Scott Morrison delivering the Mid Year Economic and Fiscal Outlook, the new record levels for government debt were confirmed, notwithstanding a small narrowing in the budget deficit which was driven by an unexpected rise in the iron ore price which fed into company profits and taxes paid to the government, as well as higher superannuation taxes based on the solid performance of the stock market last year.

The budget is forecast to return to surplus in 2020-21, but this will require everything to ‘go right’ with the economy between now and then. GDP growth is forecast to pick up to 3 per cent in 2018-19 which, according to Treasury, will underpin a solid rise in employment and a further acceleration in wages. A stronger economy will deliver higher taxes which is the driver of the return to surplus, so the theory goes.

The illion Business Expectations Survey presented a positive outlook for the economy.

Business profits expectations for 2018 are the highest they’ve been since 2011, with companies set to boost employee numbers in the first quarter on the back of the positive outlook, according to illion’s latest Business Expectations Survey.

Data from the survey indicated businesses operating in the Finance, Insurance and Real estate sector had the highest profit expectations approaching the new year, followed by the Transport, Communications and Utilities sector. The survey shows that overall, the Business Expectations Index is up 25.7 percent on the same period last year and the actual performance of businesses across all sectors is at a 13 year high.

Stephen Koukoulas, illion Economic Adviser, said there were a number of factors driving the positive outlook for 2018. “Corporate profits are getting a boost from lower costs, which are being driven by record low interest rates and on-going low wages growth – which is all occurring at a time of solid gains in the ASX”.

Word has it that the framing of the budget, due to be handed down by Treasurer Josh Frydenberg the day after April fools day (and around 6 weeks before the election), is more problematic than usual.

Problematic because there is some mixed news on the economy that will threaten the current forecast of a return to budget surplus in 2019-20.

Housing has gone into near free-fall, both in terms of prices and new dwelling approvals. This is bad news for GDP growth. The unexpected severity of the housing slump is the key point that will see Treasury revise its forecasts for GDP growth, inflation and wages lower when the budget is handed down.

It will be impossible for Treasury to ignore the recent run of hard data, including the weakness in consumer spending and a generally downbeat tone in the recent economic news when it sets the economic parameters that will underpin its estimates of tax revenue and government spending and therefore whether the budget is in surplus or deficit.

The prospect that interest rates will be lowered within the next few months is already starting to impact on the economy.

Here’s how.

Around the middle of 2018, financial markets were expecting the RBA to hike official interest rates to 1.75 or 2 per cent over the course of the next 18 months or so. If proof was needed that investors and economists can get it wrong, markets are now pricing in official interest rates to be cut towards 1 per cent over the next 18 months.

The about face has been driven by a raft of disappointing news on the economy, most notably the fall in house prices, the free-fall in new dwelling building approvals and a slump in retail spending growth.

Business confidence has also taken a hit and job advertisements have been falling for eight straight months. Ongoing low inflation and increasing signs of a slowdown in the global economy have simply added to the case for this dramatic change in market pricing.